Scottish Oriental Smaller Companies — Long-established Asian small-cap specialist

As shown in the left-hand chart of Exhibit 2, Asian and global equities have performed strongly over the past 18 months and many indices are at, or near, all-time highs. This has been in response to synchronous global growth and an unprecedented, extended period of low interest rates. Central banks, including in the US and the UK, have started to increase interest rates; however, market expectations are for monetary conditions to remain reasonably accommodative. Nevertheless, monetary conditions appear to have little scope to become more favourable, while equities valuations are not cheap. As shown in the right-hand chart, Asian equity valuations, however, are lower than global valuations on both P/E and price-to-book measures, while IMF forecasts predict faster compound annual GDP growth in Asia of 5.9% between 2017 and 2022, compared to 3.7% for global GDP growth. Investors looking for exposure to faster-growing economies may be interested in a fund with a bottom-up and disciplined approach to investing in companies on reasonable valuations.

SST aims to achieve long-term capital growth by investing mainly in smaller Asia ex-Japan listed companies with market capitalisations under $1.5bn at the time of investment. The investment approach is high-conviction and fundamental to building a portfolio of quality companies that can be held for the long term, ideally for five years or more. Vinay Agarwal formally assumed the role of lead portfolio manager in July 2017, having been acting lead manager during Wee-Li Hee’s maternity leave since July 2016. Since her return in July 2017, Hee has assumed the role of co-portfolio manager, in accordance with her wishes, thus providing continuity of the portfolio management team. Agarwal has not changed the investment philosophy and process, although there has been a shift in the portfolio, which has become more concentrated. There are currently around 60 holdings in the portfolio, down from over 80 stocks c 18 months ago, and the manager expects this to settle soon at around 50 stocks. Portfolio turnover has therefore been uncharacteristically high, above 50% in the past year, although should return to the previous norm of 20% or less once restructuring is complete.

Although gearing is permitted, up to 50% of net assets, this has been little used, and as at end-November 2017, the fund had net cash of 7.8%. A £20m loan facility was repaid early in June 2017.

Following strong performance by Asian stock markets in 2017, the manager finds it challenging to find attractively valued, high-quality companies. This is reflected in the portfolio’s relatively high cash position of 7.8% as at end-November 2017, and the decision to repay early a £20m loan facility, originally designed to give the fund flexibility to acquire positions opportunistically should markets fall to attractive levels.

Agarwal believes earnings growth has been “lacklustre” outside of a relatively narrow group of mainly technology names, with a trend for margin expansion being driven by falling input prices, which he views as unsustainable. Meetings with companies conducted by the manager and his team have revealed weak volume growth and poor pricing power given consumers’ low inflation expectations. Meanwhile, ‘cheap money’ has resulted in capital misallocations and increased competition, while pushing up levels of household debt. Agarwal notes debt levels are now more worrying in Korea and China and could become a constraint on growth. Leverage is more modest, however, in India, Indonesia, the Philippines and Sri Lanka, which together accounted for 48.5% of the portfolio as at end-November 2017. Agarwal continues to favour domestically oriented companies that have plenty of scope for structural growth, and are less influenced by external factors. He also finds more interesting opportunities in underpenetrated markets where good prospects for volume growth and premiumisation (whereby rising disposable income permits consumers to upgrade to higher-value products and services) can support sustainable long-term earnings growth.

The most significant source of investment ideas comes through country and company visits. The equity team conducts over 1,000 direct company meetings throughout the year to identify those that meet their criteria to allow them to invest with high conviction over a five-year or longer-term time horizon. Company founders and management teams are scrutinised for their integrity, risk awareness and the ability to deploy capital successfully. SST seeks high-quality franchises that have predictable and sustainable growth prospects, at reasonable valuations with a five-year perspective. Macroeconomic and political considerations are not expressly considered, as the manager is looking for well-managed, strong franchises that can perform well through economic cycles. There are no country and sector weighting constraints to portfolio construction, and portfolio risk is mitigated through the team’s in-depth knowledge of its companies and managements and a mind-set to protect capital, generating absolute, not relative returns.

SST’s managers are focused on stock selection and the portfolio can diverge significantly from its benchmark, as shown in Exhibits 3 and 4. Exhibit 4 also includes sector weights within the MSCI Asia ex-Japan Small Cap Index as a comparator. The portfolio comprises around 60 stocks, well-diversified across countries and sectors.

SST continues to favour industrials (18.6%) and consumer-related sectors (29.1% discretionary and staples combined). At end-November 2017, compared to the previous year, the consumer discretionary sector weight increased by 2.1pp to 17.8%, while consumer staples declined by 3.9pp to 11.3%. This shift reflects Agarwal’s preference for higher growth stocks over lower growth, value stocks in the staples sector. The information technology sector has also declined significantly, by 3.5pp to 9.8%. This is the portfolio’s most significant sector underweight relative to the index weight of 32.3%. Broadly, technology stocks in Asia have performed very strongly and, in the manager’s view, command unjustifiably rich valuations.

The biggest country weight changes over the past year to end-November 2017 are reductions in China (-5.7pp) and Singapore (-5.3pp) in favour of the Philippines (+4.9pp) and India (+3.2pp). SST also invested, for the first time, in Pakistan and continued to build on initial positions in Bangladesh and Vietnam. These changes reflect the manager’s observations that the more developed countries within Asia have higher household leverage, and growth prospects for companies are more challenged compared to countries with relatively low levels of debt, in particular India, Indonesia and the Philippines. The less-developed countries also have significantly lower levels of penetration of consumer goods and services, which augurs well for long-term structural growth prospects. Recent new purchases reflect these views, including Delta Brac and Indus Motor.

Housing finance company, Delta Brac is SST’s maiden position in Bangladesh. It is the largest mortgage lender with a 22% market share, where mortgages are 4% of GDP versus 9% in India, and 56% in Singapore. The company was founded by India’s blue-chip, premier housing finance company, HDFC, which is well-known to and highly regarded by the manager. HDFC owns around 15% of Delta Brac and is actively engaged with the company as a strategic shareholder, including the training of its management and assistance in the development of robust risk systems.

SST’s first investment in Pakistan is Indus Motor, a joint-venture with Japanese company Toyota and the country’s largest automotive company with 44% market share. Pakistan has 15 passenger vehicles per 1,000 people, indicating significant scope for growth, compared to 22 in India and 47 in Indonesia. Indus Motor’s valuations are attractive at around a 9x forward P/E multiple and a dividend yield of c 7%.

Agarwal is pleased with the portfolio’s positioning, which is now more skewed towards higher-growth profile companies than before, with attractive long-term prospects over a five-year or longer time horizon. His valuation discipline and the low liquidity levels of some of the new positions demand patience, although he is optimistic that the repositioning process is nearly complete.

The MSCI AC Asia ex-Japan Index performance over the past few years has been significantly skewed by the strong performance of technology stocks, in particular in South Korea and China, and by ETF inflows, which polarise purchases towards large-cap stocks. These trends have been unfavourable for SST’s relative performance and its NAV total return lags its comparative benchmark over one, three and five years. The trust’s 10-year performance remains strong, showing significant outperformance over its benchmark as well as over the MSCI AC Asia ex-Japan Small Cap and FTSE All-Share indices.

SST currently trades at a 10.5% discount to cum-income NAV, slightly below its three-year average of 11.5% but towards the higher end of the range of 1.7% to 16.7% over this period. As shown in Exhibit 8, this is one of the deeper discounts among its peers, although similar to that of its most comparable peer, Aberdeen Asian Smaller Companies Investment Trust (11.0%). The board does not have a formal discount management policy, although has the ability to help manage the discount through the repurchase of shares and active promotion of the trust.

SST is a conventional investment trust with one class of share; there are currently 30.9m ordinary shares in issue. During FY17, the company bought back 60,000 shares at a cost of £542k, and subsequent to end-August 2017, a further 12,000 shares have been repurchased. There are 465,500 shares currently held in treasury.

In June 2017, the company repaid early its August 2019 £20m fixed-rate loan with National Australia Bank as its purpose to facilitate opportunistic purchases is unlikely to be utilised, given the manager’s view of unattractive market valuations and the short duration to maturity. After breakage costs, net savings to the company for the remaining term of the loan is £732,000.

First State Investment Management (UK) is paid an annual management fee of 0.75% net assets. In addition, a performance fee is payable if SST’s share price total return exceeds that of the benchmark by 10% over a rolling three-year period, capped at 1.5% of net assets. No performance fee was payable in FY17. The ongoing charge in FY17 was 0.99%, which was a 5bp reduction versus FY16.

The dividend has been maintained at 11.5p per share for FY17, payable on 19 January 2018. The board’s intention is to at least maintain annual dividends by building up revenue reserves when income permits, and draw on them when necessary to accommodate this policy. Income per share in FY17 of 6.77p (9.50p in FY16) represents 59% dividend cover, although revenue reserves at end-August 2017 are 1.4x the annual dividend, reflecting additions to reserves in recent years in FY15 and FY13. Based on the current share price, SST’s dividend yield is 1.1%.

Exhibit 8 shows a selected peer group of investment trusts, which are members of the AIC Asia Pacific ex-Japan sector, with market capitalisations over £50m. Within this group, there are many different mandates, including trusts that invest in the Pacific region, as well as income-focused funds. SST has the strongest 10-year NAV total return within this peer group. The discount to ex-par NAV ranks 11th, although this is broadly in line with its most comparable peer, Aberdeen Asian Smaller Companies Trust.

Following the resignation of Dr Janet Morgan, who retired from the board at the December 2017 AGM, SST’s board comprises five independent non-executive directors. Chairman James Ferguson and Alexandra Mackesy were appointed in 2004, and Anne West in 2010. Two new appointments were made in 2017: Jeremy Whitley was appointed in March and Andrew Baird was appointed in June – both bring significant Asian investment experience.